That age-old argument raised its head around Chez Melvin yesterday. Do I buy the best or the worst stocks? Do I want the high-P/E stocks that everyone talks about or the low-P/E stocks? Do I want to own the most exciting companies that have sexy new products, or stocks none of us have ever heard of? Which works better, momentum or value?
I have addressed this subject in this past, and better minds than mine have also tackled it. The research section at LSV Asset Management's website is full of scholarly articles on the subject. Well-known super-quant investor Cliff Asness has done some spectacular work on the value-vs.-momentum conundrum on his website.
The momentum and value approaches both work and have worked over long periods of time. If you tell me about your personality, your goals and the time frame in which you choose to operate, I can probably tell you which school of thought you should favor. If I know you and your approach to life, I can probably tell you which type of stocks should be the focus of your trading and research effort.
If your time frame is one month or less, you really are not an investor. You are a trader. Fundamentals such as earnings, sales and profit margins do not matter so much for you. You need to be aware that in this time frame, market direction is a huge factor in the stock selection process. Trading individual stocks in this time frame is simply a matter of trying to gain some excess return above and beyond the stock market. If you are bullish on the market in general, you want stocks that will rise a little farther than the indices. If you are bearish, you want stocks that will fall a little farther than the market.
If I were trading this time frame right now and were bullish, my trading universe would contain names such as Apple (AAPL), Google (GOOG) and Cisco Systems (GOOG), which are near or at new highs and have strong momentum. If I were bearish, I would be looking to short stocks such as Alliant Techsystems (ATK), Baker Hughes (BHI) or Ancestry.com (ACOM), which are flirting with new lows and lagging the market in general.
If I am trading from the long side in the one-month to six-month time frame, I am a pure momentum guy. I want stocks that have strong price momentum, earnings momentum, improving margins, exciting new products and a sexy story. I am looking for stocks that have super strong fundamentals, and I do not care what price I pay for these gems. They need to be growing and growing fast. I want institutions to be net buyers of the shares, as I need their buying pressure to push my stocks higher over my time frame. I am looking for stocks that are at or near short-term highs in price as well. This trading universe contains names such as Lululemon Athletica (LULU), Coinstar (CSTR), Under Armour (UA) and Chipotle Mexican Grill (CMG). I want great companies with strong price momentum. If the fundamentals start to slip or the price rolls over, I am out of the stock. In this time frame, I am just surfing the sweet spot.
If I am bearish, I look for the opposite. I want to short stocks that have horrid fundamentals and a lagging stock price. My universe would probably include stocks such as Lexmark (LXK), Sony (SNE) or even Skechers (SKX). I want to find stocks with poor fundamental and prices that are weakening. When trading in this time frame, you want to keep in mind that predicting the direction of the stock market is still very much part of your decision. Determining market direction correctly will be a large component of overall return.
Successful practitioners of this approach say that occasionally they get a stock in their portfolio that stays in buy mode for an extended period of time. Fundamentals keep improving, and the stock keeps showing positive price momentum. Stocks such as Apple and Priceline.com (PCLN) might be examples. They can be tremendous wealth builders, but my friends tell me that they are always long (or short) all of their stocks, including the big winners, from last night. The fundamentals need to keep improving (or deteriorating) each quarter, and the price needs to continue to show strength (or weakness) measured against the broader market.
Value and momentum both work. Choosing the approach that best fits your time frame and personality are the key to making them work for you. Tomorrow I will discuss longer time frames and approaches and how to select investments that should work in those frameworks.